How does an active investor get out of bed in the morning and feel like she has a fighting chance at outperforming the market?
These days, it’s very hard. The Financial Times recently quoted active investor Dennis Lynch saying, “If somebody asked me to make the argument for active management, I would find it difficult given the statistics.” When Dennis Lynch, who has had success as an investor, says that, it’s a grim state of affairs for active investment indeed. But the fact is that only a small percentage of active managers outperform the market.
As assets flow from active to passive index funds at scale, active investors around the world are being forced to question their very existence. Even some of those with the best track records are going through difficult performance periods. They know that you need to go through shorter periods of underperformance in order to outperform over longer ones. Yet for many, the current period of underperformance has been longer and deeper than any in the past. And full disclosure: we also are active investors and we also have experienced difficult periods.
In light of the growth of passive investing, there have been some interesting and spirited responses from active managers. One is that underperformance hasn’t increased because active investment managers don’t have skill. On the contrary, it’s because too many of them are too highly skilled – and when the field gets that competitive, outperformance gets much harder.
Investor Michael Mauboussin has said investment today is like sports, where athletes have gotten so much better overall that standing out has gotten harder. When the whole field gets better, it gets harder to hit over 400 – which may be why Ted Williams was the last player to do so in 1941. “The difference between the best and the average manager is narrowing,” he says, “so the results get narrower. We saw it at the Olympics: The gold medalist wasn’t that much faster than the athletes who won the silver and the bronze. That’s also happened in investing.”
It’s also been pointed out that passive index investors are riding on the coattails of the hard work of active investors. Passive investors need for prices to move, and active investors are the ones that make them move. By conducting research and determining the fair value of assets, active investors provide the price discovery mechanism in the market. Paul Smith, the President and CEO of CFA Institute, recently wrote:
“Passive investors are essentially free riders, piggybacking off active managers at a fraction of the expense it takes to research investment positions. No one in the investment press focuses on this moral hazard or on whether or not this is fair to active investors, who effectively subsidize their passive brethren. The media question the value of active management, but they never bother to acknowledge that without it passive investment wouldn’t exist, let alone thrive.”
Indeed, one parlor game is to think about the point where too great a proportion of investment assets get passively invested, and the market mechanism breaks down.
And then, there’s just plain old complaining about the kind of investment environment we’re in – one where central bank policy determines all and fundamental valuation doesn’t seem to matter. John Authers of the FT recently wrote that stockpickers “desperately need a ‘stockpickers’ market’ – a period when the market as a whole is flat, but when stocks vary greatly.” And while we have had some stockpickers’ markets since the financial crisis, they seem merely to punctuate longer periods where interest rate policy dominates all.
So how does an active manager go on?
First, to be an active manager, one has to believe that assets sometime get mispriced and that those mispricings are big enough to take advantage of. As long as you still believe that, there is a rationale for active management. Ben Inker of asset manager GMO, laid out a good case for this in a recent quarterly letter (https://www.gmo.com/docs/default-source/public-commentary/gmo-quarterly-letter.pdf).
Next, one has to think about differentiating advantage. Michael Mauboussin has said that in order to outperform, you need to have an edge, and for him, there are three kinds of edge: better knowledge, better behavior, or better institutional structure.
In a world where new information gets disseminated instantly and thousands of very smart, competitive people strive to outperform each other, it may well be that finding a knowledge advantage is hard. But bad investment behavior still abounds. Because people are people, they continue to herd, get impatient, and give up on lonely positions too early. That suggests that the potential for behavioral advantage is great for those who are patient, long-term, and willing to stray far from the benchmark.
Finally, there is great room for innovation when it comes to building firm structures that facilitate better investment thinking. The investment industry -- which is so good at analyzing the structure of other industries but perhaps not its own -- probably has overcapacity. It has gotten a little too used to doing things in a certain way. It almost certainly is facing significant pricing pressure soon. And it is likely facing industry consolidation and right-sizing. But for those firms that can set themselves up to deliver better decision-making and value for the client, there may well be a rationale for carrying on yet.